What the Fed’s Outlook Means for the Bond Market

Interest rates have been highly unpredictable in recent years due to factors like inflation, economic growth, and actions by the Federal Reserve. For instance, the 10-year U.S. Treasury yield climbed from 3.8% at the end of last year to a peak of 4.7% in April, before stabilizing around 4.2% more recently. These higher rates have surprised investors and economists alike, posing challenges for the bond market since increasing rates lead to falling bond prices. However, with inflation showing signs of improvement, many now anticipate that the Fed might start cutting rates by the year's end. Diversified investors need to maintain a balanced perspective and consider the evolving economic landscape as they make investment decisions in the coming months.

Improving inflation is supporting the bond market

Recent economic reports indicate a potential improvement in inflation. Following hotter-than-expected readings in the first quarter, the latest Consumer Price Index data showed no change in overall prices in May for the first time in nearly two years. Core CPI increased by 0.2% in May, resulting in a 3.4% year-over-year rise, a notable slowdown from the previous month’s 3.6% rate. Although housing costs remain elevated, excluding them brings core inflation to just 1.9% over the past twelve months. Additionally, the Producer Price Index has shown deflationary trends after previously exceeding expectations.

These changes, along with updated guidance from the Federal Reserve, have recently led to lower rates, which in turn has bolstered bond prices. The Bloomberg U.S. Aggregate Bond Index, a comprehensive measure of the bond market, is now flat on the year after having fallen by as much as 4% in April. Investment-grade and high-yield bonds are now posting gains for the year as well. This marks a significant reversal from 2022 when bonds entered a bear market during a historic rise in interest rates, before stabilizing and rebounding in 2023.

When interest rates decrease, bond prices generally increase because the yields on existing bonds become more attractive. For instance, the yield on the investment-grade bond index is currently around 5.3%, significantly higher than the 15-year average of 3.7%. High-yield bonds and mortgage-backed securities are offering yields of 7.9% and 5.1%, respectively.

The importance of these yield levels is considerable. For much of the period following the 2008 financial crisis, investors were concerned that yields would remain low indefinitely, as policy rates stayed near zero or even went negative in some regions. Investors who depended on their portfolios for income had to "reach for yield," taking on additional risk by purchasing riskier bonds or switching to dividend-paying stocks. Today, despite the volatility in prices, retirees and long-term investors can take advantage of the most attractive yields seen in years.

The Fed is still expected to cut rates later this year

While performance numbers are always subject to change, they suggest the potential for rate cuts later this year and stabilizing inflation rates. This is crucial because market expectations for Fed rate cuts have been highly volatile this year, causing fluctuations in longer-term rates. In January, fed funds futures indicated that the Fed might need to cut rates several times due to a potential recession. However, as the economy remained robust and inflation stayed high, these expectations reversed.

Inflation rates are still above the Fed’s target, but recent improvements align with policymakers' goals. Higher policy rates are intended to tighten economic activity, curb spending, and control inflation. In their latest statement following the CPI report, the Fed noted “modest further progress toward the Committee’s 2 percent inflation objective.”

At his press conference, Fed Chair Jerome Powell highlighted the “two-sided risks” of maintaining a higher fed funds rate for an extended period. While high policy rates help combat inflation, they can also slow the economy in undesirable ways. For example, last year’s banking crisis was partly due to the impact of rising rates on banks with significant exposure to rate-sensitive long-term bonds, commercial real estate, cryptocurrencies, and more.

The Fed’s latest projections include one rate cut later this year, down from an earlier forecast of three cuts, with the remaining two cuts anticipated next year. This cautious approach should be viewed skeptically as these forecasts are frequently revised. Timing was an issue since the latest positive CPI data were released just hours before the Fed’s announcement. Market-based indicators still suggest that two rate cuts are possible this year, likely occurring in September or November.

Bonds can still provide portfolio balance

If rates finally ease, the traditional role of bonds as portfolio diversifiers could be reinvigorated. Historically, bonds have helped balance portfolios because they typically move in the opposite direction of stocks. For instance, when the economy and stock market falter, interest rates tend to drop, which supports bond prices.

This pattern was especially pronounced starting in the mid-1980s, as steadily declining interest rates led to higher bond prices over the next 40 years. This allowed both stocks and bonds to enjoy a strong bull market, with bond prices remaining stable and even rising during periods of stock market turmoil. However, 2022 saw a reversal of these trends, with both asset classes falling due to unexpected inflation. These dynamics called into question the traditional role of bonds as portfolio stabilizers and reliable sources of yield and returns.

What does the future hold for the relationship between stocks and bonds? If inflation improves and the Fed is able to cut rates, traditional patterns could reemerge. Historical data shows that inflation scares and monetary tightening, such as in 1994, 1999, and 2013, can lead to poor bond returns. However, once these episodes pass, investors have tended to return to bonds as key sources of yield and portfolio diversification.

Although the last two years have been challenging for diversified investors, the potential for more stable rates makes bonds increasingly attractive. In the meantime, staying diversified across asset classes is crucial as the Fed nears its first rate cut and price pressures across the economy continue to ease.

The bottom line? Bonds continue to be an important part of any diversified portfolio. While the outlook remains uncertain, improving inflation and the possibility of Fed rate cuts could be positive for the bond market in the months ahead.